In a previous article, we introduced the
CFA Institute Investment Foundation Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7
modules, covering all the essential topics in finance, economics, ethics and
regulations. This series of articles
will highlight the core knowledge of each chapter.
Chapter 19 provides an overview of the performance
valuation. The learning outcome of chapter 19 is as follows:
·
Describe
a performance evaluation process;
·
Describe
measures of return, including holding-period returns and time-weighted rates of
return;
·
Compare
use of arithmetic and geometric mean rates of returns in performance
evaluation;
·
Describe
measures of risk, including standard deviation and downside deviation;
·
Describe
reward-to-risk ratios, including the Sharpe and Treynor ratios;
·
Describe
uses of benchmarks and explain the selection of a benchmark;
·
Explain
measures of relative performance, including tracking error and the information
ratio;
·
Explain
the concept of alpha;
·
Explain
uses of performance attribution.
The calculation and analysis of
reward-to-risk ratios allow an understanding of the price fund investors have
to pay in terms of units of reward for each unit of risk—the total return—generated
by the fund’s manager. All things being equal, a manager who produces a
consistently high reward-to-risk ratio could be said to be more skilful than
one who consistently produces a lower ratio. Investors who invest in a fund
that is managed on an active rather than on a passive basis are effectively
paying for the manager’s investment skill and expertise.
Fund manager skill is often referred to
as alpha. Perhaps the best way to explain the concept of alpha is to consider
the sources of a fund’s return, which is composed of three elements:
·
market
return
·
luck
·
skill
Managers of passive investment funds aim
to produce returns for investors. These managers, however, are not looking to
add value to the portfolios by picking securities that they believe will
outperform other securities. Instead, they typically buy and hold in the
appropriate proportions those securities that comprise their benchmark.
Although this process requires some skill, it is not so much investment skill
as efficient administration. When the passive benchmark rises, the value of the
passive fund tracking it should also rise; conversely, when the benchmark
falls, the value of the passive fund should also fall. Therefore, over time,
the fund should produce a return similar to that of the chosen benchmark minus
fees.
Some of the return generated by an
investment fund is the result of luck rather than judgement. The prices of
financial assets held in portfolios are affected by events that cannot be
foreseen by a fund manager.
Skilful fund managers may be unlucky on
occasion and unskilled fund managers might enjoy some good luck. Because luck
tends to even out over the long term, it is vital that investors are able to
distinguish luck from skill. However, it is not always easy to do so.
A skilful fund manager is able to add
value to a portfolio over and above changes to the portfolio’s value that are
driven by market movements and that could have been produced by a passive fund
manager.
Because luck will tend to even out over
time, a skilful manager is one who adds this value consistently over time, year
after year. This outperformance over the returns from a relevant market
benchmark is generally referred to as alpha.
Performance evaluators try to
distinguish between these three sources of fund manager return. To do so,
factor models are used to determine the factors that make up returns and the
importance of each factor. One such model is the capital asset pricing model
(CAPM), from which the term alpha comes. This model includes a measure of
systematic risk: beta. Systematic risk (also called market or non-diversifiable
risk) is the risk that affects all risky investments and cannot be diversified
away. Factor models, such as the CAPM, separate a fund’s performance into
return from market performance (beta), from luck or randomness, or from the
investment skills of the fund manager (alpha).
Benchmarks can also be used to explore
the reasons for the fund manager’s performance. By using appropriate financial
market indices, the fund manager’s performance can be decomposed to reveal the
sources of returns. Depending on the nature of the fund, the performance itself
might come from the following sources:
·
asset
allocation
·
sector
selection
·
stock
selection
·
currency
exposure
Knowing how a fund manager’s performance
is derived is useful information both for the clients of the fund and for the
investment management company. For example, if a fund manager is skilled at
stock selection but less proficient at sector selection, another fund manager
may be asked to give advice on the sector selection aspect of the portfolio,
allowing the first fund manager to concentrate on stock selection. Knowing the
strengths of fund managers can also help investors choose an investment fund.
Modern performance attribution software
can allow investment management companies to drill down into the detail of a
fund to reveal all of this performance information. By doing so, the company
may conclude that a particular fund manager is very good at stock selection but
weaker in sector selection. Given this information, the company might ask
another manager with better sector selection skills to make sector-related
decisions, allowing the first manager to continue to add value through picking
stocks.
No comments:
Post a Comment